Assessment of LCH Limited's SwapClear Service 1. Summary of Regulatory Priorities

This section summarises progress on the Bank's current regulatory priorities and areas of supervisory focus and outlines the focus of the Bank's supervisory activity for the next assessment period.

As a systemically important overseas CS facility, LCH Ltd is assessed against the CCP Standards over a rolling four-year period.^[1] Certain standards may be reviewed more frequently depending on market and business developments, as well as the priorities of the Bank. These detailed compliance assessments are not published.

The Bank made the decision to defer the assessment of a number of standards this year, recognising the potential financial and operational risk management challenges presented to LCH Ltd by the COVID-19 pandemic.

1.1 Review of 2019/20 Regulatory Priorities

The Bank sets regulatory priorities for LCH Ltd based on its annual assessment. These priorities reflect the Bank's expectations regarding actions that LCH Ltd should take to enhance its observance of the CCP Standards and promote stability in the Australian financial system.

1.1.1 Extension of operating hours

LCH Ltd provided the Bank with a plan to address this regulatory priority over the medium term. Through the year, the Bank received regular updates on the technical and risk management challenges involved in extending the operating hours of the SwapClear service. LCH Ltd also continues to investigate the potential impact of business developments, including the transition to risk-free benchmarks (section 2.3), on its operating hours. As this work is ongoing, the Bank has carried this regulatory priority forward to the 2020/21 assessment period (section 1.3.1).

The SwapClear service is officially open from 6am UK time to 7pm New York time, but can open two hours earlier at LCH Ltd's discretion.^[2] In practice, LCH Ltd opened the service at 4am UK time on most business days during the assessment period despite ongoing business developments and challenges associated with COVID-19. Even so, the service remains closed for at least four hours of the Australian business day and until 3pm AEDT on Mondays during the Australian summer. Until the SwapClear service opens and trades can be novated, firms are required to manage bilateral credit risk exposures. A further extension to LCH Ltd's operating hours would mitigate this risk. In the next assessment period, LCH Ltd is expected to deliver on its plan, and continue to provide the Bank with regular updates on its progress while maintaining the safety and resilience of its operations.

1.1.2 Protected Payment System contingencies

LCH Ltd has developed enhancements designed to improve the effectiveness of its PPS contingency arrangements. At this stage, the enhancements are yet to be fully embedded in its processes and scalability has not been demonstrated through a wide-scale test. Accordingly, this regulatory priority has been carried forward to the 2020/21 assessment period (section 1.3.2).

LCH Ltd operates the PPS to settle cash payments to and from participants. LCH Ltd calls funds from, or pays funds to, clearing participants across the books of PPS banks (commercial settlement banks) acting on behalf of those participants. PPS banks then make or receive payments to or from the LCH Ltd ‘concentration bank’ via the relevant real-time gross settlement system for each currency.

In the event of a PPS bank outage, LCH Ltd requires its participants to have access to contingency arrangements so that they can continue to make and receive payments. The default contingency method, direct funding, involves participants paying directly into LCH Ltd's concentration bank account to meet calls; LCH Ltd would similarly make payments to participants directly from its concentration bank account.

During the assessment period, LCH Ltd conducted a test of improvements that have been made to its direct funding contingency arrangements with a small group of participants. Compared with previous tests, this test demonstrated a reduction in the time taken by LCH Ltd to issue and process margin calls to participants across major currencies (GBP, USD and EUR). LCH Ltd continues to explore complementary contingencies, such as utilising existing commercial relationships or establishing backup PPS banking arrangements, to allow participants flexibility as individual circumstances may dictate.

In the next assessment period, LCH Ltd has plans to make further enhancements to its direct funding contingency arrangements and to conduct a larger test. LCH Ltd should demonstrate that its enhanced arrangements have been embedded in its processes and that it has the capacity to meet service targets in the event of a PPS bank outage.

1.2 Progress in 2019/20 Areas of Supervisory Focus

Areas of supervisory focus describe matters that the Bank currently considers to be an important part of its supervision of LCH Ltd's SwapClear service. This may be due to changes underway at LCH Ltd, updates to regulatory standards, or other developments such as changes to the broader risk environment.

1.2.1 Operational and cyber risk management

During the assessment period, LCH Ltd took steps to improve its management of operational and cyber risks. Adjustments to policies and procedures covering key aspects of its resilience framework for managing distinct types of operational risk have been embedded (Appendix B), including for its management of related entities and outsourced critical service providers. LCH Ltd has also completed several action items from its resilience program related to cyber risk. As the work to improve cyber resilience is ongoing, the Bank will continue to monitor LCH Ltd's management of cyber risk in the next assessment period (section 1.4.1).

LCH Ltd has made enhancements to the management of its relationship with LSEG's Business Services Limited (BSL), a critical service provider. This has included embedding changes to its service level agreement and demonstrating that these changes have been effective. Additionally, LCH Ltd improved risk controls governing its relationship with BSL, enhancing its oversight of this critical service provider. Following these developments and the updating of operational risk policies and procedures, the operational aspect of this area of supervisory focus has been closed.

LCH Ltd has continued to refine its approach to cyber risk management and is working to embed relevant policies and controls to mitigate key areas of cyber risk. The Bank will continue to monitor LCH Ltd's cyber risk management, including its work to sustain improvements to its cyber resilience. The Bank will continue to engage regularly with the BoE on this issue.

1.2.2 Model validations

During this assessment period, LCH Ltd demonstrated that it performed annual model validations in line with its policies, and benchmarked its high importance models against industry practice. LCH Ltd is working towards documenting its policy regarding its criteria for benchmarking its models.

LCH Ltd's benchmarking processes and procedures should be appropriately documented to minimise key-person risk and to allow review by LCH Ltd's internal audit function and governance processes. This documentation should include the frequency at which benchmarking is undertaken and the criteria used to determine appropriate benchmarking standards. LCH Ltd has sought to undertake these changes, and the Bank will assess updates to LCH Ltd's model validation procedures in the next assessment period (section 1.4.2).

1.3 2020/21 Regulatory Priorities

1.3.1 Extension of operating hours

The regulatory priority on extending SwapClear's operating hours has been carried forward from the 2019/20 assessment period as the SwapClear service remains closed for at least four hours of the Australian business day (section 1.1.1). In the next assessment period, LCH Ltd should continue the implementation of its plan to extend SwapClear's operating hours.

1.3.2 Protected Payment System contingencies

This regulatory priority has been carried forward from the 2019/20 assessment period. While LCH Ltd has made progress in improving its PPS contingency arrangements, there remains work to be done to embed relevant processes and improve operational efficiency during a PPS outage (section 1.1.2). During the next assessment period, LCH Ltd should conduct a large scale test of its PPS direct funding contingency arrangements to ensure processes are sufficiently understood and embedded.

1.4 2020/21 Areas of Supervisory Focus

1.4.1 Cyber risk management

This area of supervisory focus has been amended from the 2019/20 area of supervisory focus on operational and cyber risk management (section 1.2.1). During the next assessment period, the Bank will monitor the outcomes of ongoing work by LCH Ltd to enhance the effectiveness of its cyber risk management.

1.4.2 Model validations

This area of supervisory focus has been carried forward from the 2019/20 assessment period (section 1.2.2). The Bank will monitor steps to address this area in the next assessment period.

1.4.3 Legal basis

The Bank intends to conduct a targeted review into certain aspects of LCH Ltd's legal basis, commencing in the next assessment period. The Bank intends to limit the scope of the review to Australian law issues, which will need to be addressed in a new Australian legal opinion. The Bank will continue to liaise with LCH Ltd and other regulators throughout the review.

Footnotes

For more information see the Reserve Bank's Approach to Supervising and Assessing Clearing and Settlement Facility Licensees. Available at <https://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/standards/approach-to-supervising-and-assessing-csf-licensees.html>. [1]

The official opening hours correspond to 3pm-9am AEST in the Australian winter, and 5pm-11am AEDT in the Australian summer. Differences in when the Australian states, New York and the UK transition in and out of daylight savings may affect these times. [2]